Low-Rate Rules for Borrowers and Savers

The borrower’s best bet is to lock in today’s low interest rate for the long term. This is a great opportunity to get a 30-year fixed-rate mortgage. They average just 5.163%, according to the BankingMyWay.com Survey. With the search tool you can find even better deals, like the 5.083% charged by Bank of America (Stock Quote: BAC).

At the other extreme of the mortgage lineup is the one-year adjustable-rate mortgage. They start at an appealing 4.242%, which could save you some money in the first 12 months. But who knows what the rate could adjust to after that? Rates are so low now that they’re more likely to rise than fall in coming years, as the Fed’s definition of an “extended period” for low rates could conceivably mean a year or two, but certainly not 10, 20 or 30.

If an adjustable-rate loan starts charging more a year or two from now, it will probably be too late to refinance and get the rock-bottom fixed rate available today. There’s little doubt about it: For home buyers, fixed rates are more appealing than adjustable ones.

The choice is a little tougher for homeowners who already have adjustable-rate loans and are thinking of refinancing. The indexes used in those adjustments are at low levels, providing lots of bargains. Many one-year ARMs, for example, adjust by adding 2.75 percentage points to the rate on Treasury securities with one year to maturity. With that rate at an astounding low of 0.39%, these ARMs can adjust to 3.14%.

The problem, of course, is that those rates can go higher in the future, perhaps much higher than the 5.2% rate you could get by refinancing to a fixed-rate loan today. It would not be pleasant to pay steep fees to refinance to a fixed loan today that actually gives you a higher payment than your old ARM does, but that could be the smartest move in the long term.

Note that the results can be quite different depending on the value you insert for “expected rate change,” an annual increase in rate charged by the ARM. The bigger the number, the less likely it is that the ARM would be cheaper over the long run. No one knows, of course, how the ARM indexes will move. But it’s prudent to look at the worst case possible, the largest annual hikes the loan terms allow, typically two percentage points.

The saver’s strategy is the opposite of the borrower’s. These days savers should generally avoid locking in for the long term.

The first problem with long-term fixed-income investments is that it’s hard to get your money out if you have an opportunity to buy something more generous. Buy a five-year certificate of deposit at today’s average rate of 2.285% and you’d kick yourself if newer CDs paid 5% a couple of years from now.

The second problem with locking in is that many investments, such as government and corporate bonds, lose value when interest rates rise, since investors won’t pay full price for older bonds that are less generous than new ones.

In today’s conditions, fixed-income investors should emphasize safety and liquidity, which is the ability to get at your money to move it elsewhere. Short-term CDs and money market accounts won’t make you rich, but they’ll help keep your options open for the future.